Methods of Repurchasing Stock
Methods of Repurchasing Stock
A corporation may repurchase its own stock by any of three methods: (1) a tender offer, (2) open market purchases, and (3) a targeted share repurchase.
Tender Offer
A tender offer is an offer made to all shareholders, with a specified deadline and a specified number of shares the corporation is willing to buy back. The tender offer may be a fixed price offer, where the corporation specifies the price it is willing to pay and solicits pur- chases of shares of stock at that price. For example, The Limited Inc. made a repurchase tender offer in early 1996, offering to buy up to 85 million of its shares for $19 a share at a time when its shares were trad- ing for $16.50 a share.
18 The phrase “dividend puzzle” originates from Fischer Black, “The Dividend Puz- zle,” Journal of Portfolio Management (Winter 1976), pp. 5–8.
FINANCING DECISIONS
The tender offer may also be conducted as a Dutch auction in which the corporation specifies a minimum and a maximum price, soliciting bids from shareholders for any price within this range at which they are willing to sell their shares. After the corporation receives these bids, they pay all tendering shareholders the maximum price sufficient to buy back the number of shares they want. A Dutch auction reduces the chance that the firm pays a price higher than needed to acquire the shares.
To illustrate how a Dutch auction works, suppose a corporation wants to buy back 1 million shares of common stock currently trading for $25 a share. If the firm make a tender offer for the shares, it must specify the price it is willing to pay. The price must be higher than $25, or no one will be willing to sell back the shares. Because it is sometimes difficult to figure out just how much more to offer, the firm can use a Dutch auction. A Dutch auction sets the buying price for the item on the basis of bids.
For example, the firm could make a Dutch auction tender offer, specifying that it wants to buy back 1,000,000 shares, offering to buy at
a minimum price of $26 and a maximum price of $29. Shareholders who want to tender their shares—sell them back to the corporation— specify how many shares they are willing to sell and at what price. Sup- pose the shareholders respond as follows:
Number of Shares Willing to Tender
Specified Price
The corporation will accept the first 1,000,000 shares in order of price, paying only one price and not higher than necessary to get that 1,000,000 shares. In this example, the corporation would pay $28 per share of the 1,000,000 shares. The shareholders that specified they would tender their shares at $29 per share are out of luck. The share- holders who bid $26 and $27 are paid more than the price at which they were willing to tender.
Open Market Purchases
A corporation may also buy back shares directly in the open market. This involves buying the shares through a broker. A corporation that wants to buy shares may have to spread its purchases over time so as not to drive the share’s price up temporarily by buying large numbers of shares.
Common Stock
Targeted Share Repurchase The third method of repurchasing stock is to buy it from a specific shareholder. This involves direct negotiation between the corporation and the shareholder. This method is referred to as a targeted block repurchase, since there is a specific shareholder (the “target”) and there are a larger number of shares (a “block) to be pur- chased at one time. Targeted block repurchases, also referred to as greenmail, were used in the 1980s to fight takeovers.
Reasons for Repurchasing Stock Corporations repurchase their stock for a number of reasons. First, a
repurchase is a way to distribute cash to shareholders at a lower cost to both the firm and the shareholders than dividends. If capital gains are taxed at rates lower than ordinary income, which is often the case with U.S. tax law, repurchasing is a lower cost way of distributing cash. How- ever, since shareholders have different tax rates—especially when com- paring corporate shareholders with individual shareholders—the benefit is mixed. Why? Because some shareholders are tax-free (e.g., pension funds), some shareholders are only taxed on a portion of dividends (e.g., corporations receiving dividends from other corporations), and some shareholders are taxed on the full amount of dividends (e.g., individual taxpayers).
Another reason to repurchase stock is to increase earnings per share. A firm that repurchases its shares increases its earnings per share simply because there are fewer shares outstanding after the repurchase. But there are two problems with this motive:
1. Cash is paid to the shareholders, so less cash is available for the corpo- ration to reinvest in profitable projects.
2. Because there are fewer shares, the earnings pie is sliced in fewer pieces, resulting in higher earnings per share. The individual “slices” are big- ger, but the pie itself remains the same size.
Looking at how share prices respond to gimmicks that manipulate earnings, we know that you cannot fool the market by playing an earn- ings per share game. The market can see through the earnings per share to what is really happening and that is that the firm will has less cash to invest.
Still another reason for stock repurchase is that it could tilt the debt-equity ratio so as to increase the value of the firm. By buying back stock—thereby reducing equity—the firm’s assets are financed to a greater degree by debt. Does this seems wrong? It’s not. To see this, sup- pose a corporation has the following balance sheet:
FINANCING DECISIONS
Assets $100 Debt $50 Equity $50
The corporation has financed 50% of its assets with debt, and 50% with equity. If this corporation uses $20 of its assets to buy back stock worth $20, its balance sheet will be:
Assets $80 Debt $50 Equity $30
It now finances 62.5% of its assets with debt and 37.5% with equity. If financing the firm with more debt is good—that is, the benefits from deducting interest on debt outweigh the cost of increasing the risk of bankruptcy—repurchasing stock may increase the value of the firm. But there is the flip-side to this argument: Financing the firm with more debt may be bad if the risk of financial distress—difficulty paying legal obligations—outweighs the benefits from tax deductibility of interest. So, repurchasing shares from this perspective would have to be judged on a case-by-case basis to determine if it’s beneficial or detrimental.
One more reason for a stock repurchase is that it reduces total divi- dend payments—without seeming to. If you cut down on the number of shares outstanding, you can still pay the same amount of dividends per share, but your total dividend payments are reduced. Suppose you pay a regular, quarterly dividend of $2.00 per share. If there are 1,000,000 shares of stock outstanding, your quarterly dividend payment is $2,000,000. If you repurchase 10% of the outstanding shares and keep the dividends per share the same, your total quarterly dividend payment is $2.00 times 900,000 shares, or $1,800,000. You have reduced your payment by $200,000, yet have not changed the dividends per share.
If the shares are correctly valued in the market (there is no reason to believe otherwise), the payment for the repurchased shares equals the reduction in the value of the firm—and the remaining shares are worth the same as they were before. In our example, the repurchase reduces the equity pie by 10%—and the smaller pie comprises 10% fewer shares. Suppose the shares traded at $50 per share before the repur- chase—total equity is $50 times 1,000,000, or $50,000,000. If the firm buys back 10% of the shares—100,000 shares at $50 each—the value of the firm should decline by $5,000,000. This leaves equity worth $45,000,000. Split among the remaining 900,000 shares, the value per share is $50—the same as before the repurchase.
Some argue that a repurchase is a signal about future prospects. That is, by buying back the shares, the management is communicating to investors that the firm is generating sufficient cash to be able to buy
Common Stock
back shares. But does this make sense? Not really. If the firm has profit- able investment opportunities, the cash could be used to finance these investments, instead of paying it out to the shareholders.
A stock repurchase may also reduce agency costs by reducing the amount of cash the management has on hand. Similar to the argument we used for dividend payments, repurchasing shares reduces the amount of free cash flow and, hence, reduces the possibility that management will invest it unprofitably.
Repurchasing shares of a firm tends to shrink the firm: Cash is paid out and the value of the firm is smaller. Can repurchasing shares be con- sistent with wealth maximization? Yes.
If the best use of funds is to pay them out to shareholders, repurchas- ing shares maximizes shareholders’ wealth. If the firm has no profitable investment opportunities, it is better for a firm to shrink by paying funds to the shareholders than to shrink by investing in lousy investments.
So how does the market react to a firm’s intention to repurchase shares? A number of studies have looked at how the market reacts to such announcements. In general, the share price goes up when a firm announces it is going to repurchase its own shares.
It is difficult to identify the reason the market reacts favorably to such announcements since so many other things are happening at the same time. By piecing bits of evidence together, however, we see that it is likely that investors view the announcement of a repurchase as good news—a signal of good things to come.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
Show more